How to calculate the yield on a bond

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What is the single most important aspect you must factor in when you are choosing and comparing investment options? Most investors would consider the answer to be the returns you can expect to earn from these investments. And they would be right because the primary goal of making any investment is to earn decent returns from the asset.  Investing in bonds is no different. In the case of these debt securities, the returns are expressed in terms of the bond yield. It’s crucial to know how to calculate the bond yield and how to calculate the bond equivalent yield (BEY).  If you are not aware of the bond yield calculation formula and the computation process, this article will give you the clarity you need. Let’s begin by understanding the meaning of the bond yield

What is the Bond Yield?

Although the term sounds complex, the bond yield is essentially the amount of returns that a bond offers the investor. These returns are typically determined by the coupon rate, which is the rate at which the bond issuer pays out interest to the investor. This coupon rate is applied to the face value of the bond to calculate the interest.

For example, say you buy a bond with a face value of Rs. 10 lakhs and a coupon rate of 7% per annum. In this case, you will earn Rs. 70,000 each year. The bond yield will be equal to the coupon rate here because the returns are generated at 7% per year. 

You may be familiar with the example above because this is how investors typically calculate the returns from a bond before making an investment decision. Nevertheless, there are a few concepts and metrics related to bond yields that you must know about before you invest in bonds. Let’s take a closer look at each of them. 

Standard Bond Yield

This is the annual rate of interest that you can earn from a bond. It is simply the coupon rate, which is typically known in advance for fixed rate bonds. You need not calculate this rate from scratch again. Nevertheless, it helps to know the standard coupon rate or bond yield calculation formula.

How to Calculate the Bond Yield?

To calculate the bond yield or coupon rate, you can use the formula shown below. 

Bond Yield (or Coupon Rate) = Annual Coupon Payment ÷ Face Value of the Bond

Typically, this formula is used to calculate the annual coupon payment because the bond yield and the face value are known upfront. 

Current Yield

The current yield is the rate of return you can expect to earn from your bond during the next year. This type of bond yield depends on the current price of the bond. If the price of the bond increases, the expected rate of return (i.e. the current yield) decreases and vice versa.  

How to Calculate the Current Yield?

You can calculate this yield from the bond’s price using the formula shown below. 

Current Yield = Annual Coupon Payment ÷ Market Price of the Bond

If you are wondering how to calculate the price of the bond from its yield, you can use the above-mentioned formula for that purpose too. However, the coupon rate and the current yield are both narrow concepts. They do not account for the time value of money. This is why we have to calculate the yield to maturity of a bond. 

Yield to Maturity 

A bond yields multiple coupon payments during its lifetime. The interest rate at which the present value of all these future cash flows equals the current bond price is the bond’s yield to maturity (YTM). In layman’s terms, this is the yield that you can expect to earn from a bond if you hold it till maturity. This is why it accounts for all the future cash flows from the bond. 

How to Calculate the Yield to Maturity?

The formula to calculate the yield to maturity of a bond is as follows.

Yield to Maturity = [C + (FV — MP)/n] ÷ (FV + MP)/2 

Here, the abbreviations refer to the following parameters.

  • C is the annual coupon payment
  • FV is the face value or par value of the bond
  • MP is the current market price of the bond
  • n is the number of years to maturity 

Bond Equivalent Yield (BEY)

The bond equivalent yield (BEY) accounts for the cases where the coupon payments are made multiple times during the year. Typically, bonds pay out the interest annually. However, some bonds may offer semi-annual coupon payments. The bond equivalent yield becomes relevant in these cases. 

How to Calculate the Bond Equivalent Yield (BEY)?

If you want to know how to calculate the bond equivalent yield, you can use the formula shown below. 

Bond Equivalent Yield = [(FV – Purchase Price) ÷ Purchase Price] * 365/d

Here, the term FV refers to the face value of the bond while ‘d’ is the number of days left for the bond’s maturity. 

Conclusion

The bottom line is that you can calculate the yield from the bond price, its face value and even its future cash flows. If you are not sure about which bond yield calculation formula to use, a rule of thumb is to rely on more comprehensive parameters like the yield to maturity or the bond equivalent yield. And no matter which type of yield you use, it’s important to use the same metric to compare different bonds before you make an investment decision. 

Additional Read: The Different Types of Bonds

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